Efficiency
 Principles of
Microeconomic Theory,
ECO 284
 John Eastwood
 CBA 213
 523-7353
 e-mail address:
John.Eastwood@nau.edu
1
Learning Objectives
 Distinguish between value and price
 Define consumer surplus
 Distinguish between cost and price
 Define producer surplus
 Explain why consumer surplus and
producer surplus are the gains from trade
2
Learning Objectives (cont.)
 Explain why competitive markets move
resources to their highest-valued uses
 Explain the sources of inefficiency in our
economy
3
Learning Objectives
 Distinguish between value and price
 Define consumer surplus
 Distinguish between cost and price
 Define producer surplus
 Explain why consumer surplus and
producer surplus are the gains from trade
4
Efficiency: A Refresher
 According to economists, efficiency means
the resources have been used to produce the
goods and services that people value the
most.
5
Efficiency: A Refresher
 Marginal benefit is the benefit that a person
receives from consuming one more unit of a
good or service

measured as the maximum amount that a
person is willing to give up for one additional
unit
 Principle of decreasing marginal benefit

marginal benefit decreases as consumption
increases
6
Efficiency: A Refresher
 Marginal cost is the opportunity cost of
producing one more unit of a good or
service.

measured as the value of the best alternative
foregone
 Principle of increasing marginal cost

marginal cost increases as the quantity
produced increases
7
Marginal cost and marginal benefit
(dollars worth of goods and services)
The Efficient Quantity of Pizza
25
20
15
10
5
0
5
10
15
20
Quantity (thousands of pizzas per day)
8
Marginal cost and marginal benefit
(dollars worth of goods and services)
The Efficient Quantity of Pizza
25
MC
20
15
10
5
0
MB
5
10
15
20
Quantity (thousands of pizzas per day)
10
Marginal cost and marginal benefit
(dollars worth of goods and services)
The Efficient Quantity of Pizza
25
Pizza valued more
highly than it costs:
Increase production
MC
Pizza costs more
than it is valued:
Decrease
production
20
15
10
5
0
MB
5
10
15
20
Quantity (thousands of pizzas per day)
11
Marginal cost and marginal benefit
(dollars worth of goods and services)
The Efficient Quantity of Pizza
25
Efficient quantity
of pizza
MC
20
15
10
5
0
MB
5
10
15
20
Quantity (thousands of pizzas per day)
12
Learning Objectives
 Distinguish between value and price
 Define consumer surplus
 Distinguish between cost and price
 Define producer surplus
 Explain why consumer surplus and
producer surplus are the gains from trade
14
Value, Price, and
Consumer Surplus
 What is meant by “Value”?

Value of an item is the same thing as its
marginal benefit

Marginal benefit - the maximum price people
are willing to pay for an additional unit

Willingness determines demand
15
Price (dollars per pizza)
Demand, Willingness to Pay,
and Marginal Benefit
25
Price determines
quantity demanded
20
15
10
5
0
D
5
10
15
20
Quantity (thousands of pizzas per day)
16
Price (dollars per pizza)
Demand, Willingness to Pay,
and Marginal Benefit
25
Price determines
quantity demanded
20
15
10
5
Quantity of pizzas
demanded at $15
a pizza
0
5
10
D
15
20
Quantity (thousands of pizzas per day)
17
Price (dollars per pizza)
Demand, Willingness to Pay,
and Marginal Benefit
25
Quantity determines
willingness to pay
20
15
10
5
0
D
5
10
15
20
Quantity (thousands of pizzas per day)
18
Price (dollars per pizza)
Demand, Willingness to Pay,
and Marginal Benefit
25
Quantity determines
willingness to pay
20
15
10
5
0
Maximum price
willingly paid for
the 10,000th
pizza
5
D=MB
10
15
20
Quantity (thousands of pizzas per day)
19
Consumer Surplus
 Consumer surplus is the value of a good
minus the price paid for it.

if a person buys something for less than they
are willing to pay for it, a consumer surplus
exists
20
Price (dollars per slice)
A Consumer’s Demand and
Consumer Surplus
2.50
2.00
1.50
1.00
0.50
0
D
10
20
30
40
Quantity (slices of pizzas per week)
21
Price (dollars per slice)
A Consumer’s Demand and
Consumer Surplus
2.50
Market
price
2.00
1.50
1.00
0.50
0
D
10
20
30
40
Quantity (slices of pizzas per week)
22
Price (dollars per slice)
A Consumer’s Demand and
Consumer Surplus
2.50
Market
price
2.00
1.50
1.00
Amount
paid
0.50
0
10
20
30
D
40
Quantity (slices of pizzas per week)
23
Price (dollars per slice)
A Consumer’s Demand and
Consumer Surplus
Lisa’s consumer
surplus from the
10th pizza
2.50
2.00
Market
price
1.50
1.00
Amount
paid
0.50
0
10
20
30
D
40
Quantity (slices of pizzas per week)
24
Price (dollars per slice)
A Consumer’s Demand and
Consumer Surplus
2.50
Consumer
surplus
2.00
Lisa’s consumer
surplus from the
10th pizza
Market
price
1.50
1.00
Amount
paid
0.50
0
10
20
30
D
40
Quantity (slices of pizzas per week)
25
Demand Curves Measure
Willingness-to-Pay
 The Demand Price represents the value of the next
unit to consumers.
 The area under the demand curve to the left of a
quantity, Q, equals the total value of that level of
output to consumers.
 It is the maximum amount they would be willing
to pay for Q.
26
Consumers’ Surplus
 Consumers’ Surplus is the difference between
consumers’ maximum willingness-to-pay and the
amount they actually paid.
 The amount actually paid equals TR=PQ.
 Graphically, Consumers’ Surplus (CS) is the area
under the demand curve above Pe.
27




CS is the area
under the
demand curve
above Pe =$10.
Area (of a right
triangle)
=(1/2)bh
CS=
CS=
Price ($/bbl.)
Computing CS
20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
0 2 4 6 8 10 12 14 16 18 20
Quantity (bbl./day)
28




CS is the area
under the
demand curve
above Pe =$10.
Area (of a right
triangle)
=(0.5)bh
CS=(0.5)10(10)
CS=50 $/day
Price ($/bbl.)
Computing CS
20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
0 2 4 6 8 10 12 14 16 18 20
Quantity (bbl./day)
29
Learning Objectives
 Distinguish between value and price
 Define consumer surplus
 Distinguish between cost and price
 Define producer surplus
 Explain why consumer surplus and
producer surplus are the gains from trade
30
Cost, Price, and
Producer Surplus
 Cost vs. Price


Cost is what the producer gives up.
Price is what the producer receives.
 Marginal cost is the cost of producing one
more unit.
31
Price (dollars per pizza)
Supply, Minimum Supply-Price,
and Marginal Cost
S
25
Price determines
quantity supplied.
20
15
10
5
0
50
100
150
200
Quantity (thousands of pizzas per day)
32
Price (dollars per pizza)
Supply, Minimum Supply-Price,
and Marginal Cost
S
25
Price determines
quantity supplied.
20
15
10
Quantity of pizzas
supplied at $15
a pizza
5
0
50
100
150
200
Quantity (thousands of pizzas per day)
33
Price (dollars per pizza)
Supply, Minimum Supply-Price,
and Marginal Cost
S
25
20
Quantity determines
minimum supplyprice.
15
10
5
0
50
100
150
200
Quantity (thousands of pizzas per day)
34
Price (dollars per pizza)
Supply, Minimum Supply-Price,
and Marginal Cost
S=MC
25
20
Minimum supplyprice for 10,000th
pizza
Quantity determines
minimum supplyprice.
15
10
5
0
50
100
150
200
Quantity (thousands of pizzas per day)
35
Learning Objectives
 Distinguish between value and price
 Define consumer surplus
 Distinguish between cost and price
 Define producer surplus
 Explain why consumer surplus and
producer surplus are the gains from trade
36
Producer Surplus
 Producer surplus is the value of a good
minus the opportunity cost of producing it.

if a firm sells something for more that it costs
to produce, a producer surplus exists
37
Price (dollars per pizza)
A Producers Supply
and Producer Surplus
S
25
20
Price determines
quantity supplied
15
10
5
0
50
100
150
200
Quantity (pizzas per day)
38
Price (dollars per pizza)
A Producers Supply
and Producer Surplus
S
25
Market
price
20
15
10
5
0
50
100
150
200
Quantity (pizzas per day)
39
Price (dollars per pizza)
A Producers Supply
and Producer Surplus
Max’s producer
surplus from the
50th pizza
25
S
Market
price
20
15
10
Cost
of Production
5
0
50
100
150
200
Quantity (pizzas per day)
40
Price (dollars per pizza)
A Producers Supply
and Producer Surplus
Max’s producer
surplus from the
50th pizza
25
20
S
Market
price
Producer
surplus
15
10
Cost
of Production
5
0
50
100
150
200
Quantity (pizzas per day)
41
Price (dollars per pizza)
A Producers Supply
and Producer Surplus
25
S
Producer surplus
equals profit
Market
price
20
15
10
Cost
of Production
5
0
50
100
150
200
Quantity (pizzas per day)
42
Supply Curves Measure Costs
 Under competitive conditions, the supply
curve represents the cost of producing the
next unit.
43
Producers’ Surplus
 . . . is the difference between the amount
producers receive, and the minimum amount they
would have been willing to accept.
 Producers receive TR =PQ.
 Graphically, Producers’ Surplus (PS) is the area
under the price line, and above Supply.
44





Producers’
Surplus (PS) is
the area under
the Pe, and
above Supply.
Area =(0.5)bh
PS=
PS=
CS+PS=
Price ($/bbl.)
Computing PS
20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
0 2 4 6 8 10 12 14 16 18 20
Quantity (bbl./day)
45





Producers’
Surplus (PS) is
the area under
the Pe, and
above Supply.
Area =(0.5)bh
PS=(0.5)10(5)
PS=25 $/day
CS+PS=75 $/day
Price ($/bbl.)
Computing PS
25
20
Demand
Supply
15
10
5
0
0 2 4 6 8 10 12 14 16 18 20
Quantity (bbl./day)
46
Learning Objectives
 Distinguish between value and price
 Define consumer surplus
 Distinguish between cost and price
 Define producer surplus
 Explain why consumer surplus and
producer surplus are the gains from trade
47
Is the Competitive
Market Efficient?
 Recall

Supply and demand will force the price toward
the equilibrium price
Question: Is this the
efficient quantity of pizza?
48
Price (dollars per pizza)
An Efficient Market for Pizza
S Marginal cost--
25
opportunity cost
--of pizza
20
15
Marginal benefit-value--of pizza
10
5
0
Efficient quantity
of pizzas
5
10
D
15
20
Quantity (thousands of pizzas per day)
49
Is the Competitive
Market Efficient?
 At Competitive Equilibrium

Resources are being used efficiently

The sum of consumer surplus and producer
surplus is maximized
50
Price (dollars per pizza)
An Efficient Market for Pizza
S
25
20
15
10
5
0
D
5
10
15
20
Quantity (thousands of pizzas per day)
51
Price (dollars per pizza)
An Efficient Market for Pizza
S
25
20
15
10
5
0
Producer
surplus
5
D
10
15
20
Quantity (thousands of pizzas per day)
52
Price (dollars per pizza)
An Efficient Market for Pizza
25
Consumer
surplus
S
20
15
10
5
0
Producer
surplus
5
D
10
15
20
Quantity (thousands of pizzas per day)
53
At Pe, both surpluses are greatest.
 At a price below Pe, fewer units are sold.



CS may be larger, but PS is smaller.
Some surplus is transferred from producers to
consumers.
Some surplus is lost.
 At a price above Pe, fewer units are sold.



PS may be larger, but CS is smaller.
Some surplus is transferred from producers to
consumers.
Some surplus is lost.
54
Learning Objectives (cont.)
 Explain why competitive markets move
resources to their highest-valued uses
 Explain the sources of inefficiency in our
economy
55
The Invisible Hand
 Adam Smith - Wealth of Nations in 1776

Participants in a competitive market is “led by
an invisible hand to promote an end (the
efficient use of resources) which was not part of
his intention.”
56
Learning Objectives (cont.)
 Explain why competitive markets move
resources to their highest-valued uses
 Explain the sources of inefficiency in our
economy
57
Sources of Inefficiency
 Price ceilings and floors
 Taxes, subsidies, and quotas
 Monopoly
 Public goods
 External costs and benefits
These lead to underproduction or
overproduction.
58
Sources of Inefficiency
 Deadweight Loss

The decrease in consumer and producer surplus
that results from an inefficient allocation of
resources
59
Price (dollars per pizza)
Underproduction
S
25
20
15
10
5
0
D
5
10
15
20
Quantity (thousands of pizzas per day)
60
Price (dollars per pizza)
Underproduction
S
Deadweight
loss
25
20
15
10
5
0
D
5
10
15
20
Quantity (thousands of pizzas per day)
61
Price (dollars per pizza)
Overproduction
S
25
20
15
10
5
0
D
5
10
15
20
Quantity (thousands of pizzas per day)
62
Price (dollars per pizza)
Overproduction
S
25
20
Deadweight
loss
15
10
5
0
D
5
10
15
20
Quantity (thousands of pizzas per day)
63
Deadweight Loss
 The area lost is known as a “deadweight
loss” because it benefits no one.
 Taxes produce deadweight losses when they
reduce the quantity traded.
 Price controls produce deadweight losses.
64
Area=0.5bh=0.5(4)6
Loss = $__/day
w/o ceiling
CS = $__/day
PS = $__/day
CS+PS = $__/day
With ceiling
CS = $__/day
PS = $__/day
CS+PS = $__/day
Price ($/bbl.)
Deadweight Loss -- Price Ceiling
20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
Ceiling
0 2 4 6 8 10 12 14 16 18 20
Quantity (bbl./day)
65
Area=0.5bh=0.5(4)6
Loss = $12/day
w/o ceiling
CS = $50/day
PS = $25/day
CS+PS = $75/day
With ceiling
CS = $54/day
PS = $ 9/day
CS+PS = $63/day
Price ($/bbl.)
Deadweight Loss -- Price Ceiling
20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
Ceiling
0 2 4 6 8 10 12 14 16 18 20
Quantity (bbl./day)
66
Deadweight Loss
 Taxes produce deadweight losses when they
reduce the quantity traded.



Remove the price ceiling
Add a $3/bbl tax on oil
What is the deadweight loss?
67
Qn = __ bbl./day
Pgross = $__/bbl.
Tax, T = $__/bbl.
Pnet = $__/bbl.
Buyers pay Pgross
Firms keep Pnet
Tax rev. =
$_/bbl x _ bbl/day)
$__/day
Price ($/bbl.)
Unit Tax as a Decrease in Supply
20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
S+Tax
0
2
4
6
8 10 12 14 16 18 20
Quantity (bbl./day)
68
Qn = 8 bbl./day
Pgross = $12/bbl.
Tax, T = $3/bbl.
Pnet = $9/bbl.
Buyers pay Pgross
Firms keep Pnet
Tax rev. =
$3/bbl x 8 bbl/day)
$24/day
Who pays?
Price ($/bbl.)
Unit Tax as a Decrease in Supply
20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
S+Tax
0
2
4
6
8 10 12 14 16 18 20
Quantity (bbl./day)
69
Area=0.5bh=0.5(2)3
Loss = $__/day
CS was = $50/day
PS was = $25/day
CS+PS = $75/day
Tax rev = $24/day
CS = $__/day
PS = $__/day
Tx+CS+PS=$__/day
Price ($/bbl.)
Unit Tax -- Deadweight Loss
20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
S+Tax
0 2 4 6 8 10 12 14 16 18 20
Quantity (bbl./day)
70
Area=0.5bh=0.5(2)3
Loss = $3/day
CS was = $50/day
PS was = $25/day
CS+PS = $75/day
Tax rev = $24/day
CS = $32/day
PS = $16/day
Tx+CS+PS=$72/day
Price ($/bbl.)
Unit Tax -- Deadweight Loss
20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
S+Tax
0 2 4 6 8 10 12 14 16 18 20
Quantity (bbl./day)
71

PS=


Compute CS & PS
Price ($/bbl.)

CS= area above
the Pe, and
below Demand
PS= area under
the Pe, and
above Supply.
Area =0.5(b)h
CS=

20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
0 2 4 6 8 10 12 14 16 18 20

CS+PS
Quantity (bbl./day)
72







CS= area above
the Pe, and
below Demand
PS= area under
the Pe, and
above Supply.
Area =0.5(b)h
CS= 0.5(10)10
CS= $50/day
PS= 0.5(10)5
PS= $25/day
CS+PS=$75/day
Compute CS & PS
Price ($/bbl.)

25
20
Demand
Supply
15
10
5
0
0 2 4 6 8 10 12 14 16 18 20
Quantity (bbl./day)
73
Area=0.5bh=
Loss =
CS =
PS =
Gov. pays the subsidy
Consumers gain or lose?
Producers gain or lose?
Price ($/bbl.)
Deadweight Loss -- Subsidy $__/bbl.
20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
S-Subsidy
0
Taxpayers?
Net benefit
2
4
6
8 10 12 14 16 18 20
Quantity (bbl./day)
74
Area=0.5bh=0.5(4)6
Loss = $12/day
CS = 0.5(14)14 = $98/day
PS = 0.5(7)14 = $49/day
Gov. pays the subsidy
=($6/bbl)14bbl day =
$84/day
Consumers gain
= 98-50 = $48/day
Producers gain
= 49 - 25 = $24/day
Taxpayers lose $84/day
Net benefit = 72 - 84 = -12
Price ($/bbl.)
Deadweight Loss -- Subsidy $6/bbl.
20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
S-Subsidy
0
2
4
6
8 10 12 14 16 18 20
Quantity (bbl./day)
75
Output Restriction (or Quota)
CS=
PS=
Consumers
Producers
Price ($/bbl.)
Output limit = 8 bbl./day
20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
0
Net Benefit =
2
4
6
8 10 12 14 16 18 20
Quantity (bbl./day)
76
Output Restriction (or Quota)
Area=0.5bh=0.5(2)3
Loss = $3/day
CS = 0.5(8)8 = $32/day
PS=8(3)+0.5(8)4= $40/day
Consumers lose
= 50 - 32 = $18/day
Producers gain
= 40 - 25 = $15/day
Price ($/bbl.)
Output limit = 8 bbl./day
20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
0
2
4
6
8 10 12 14 16 18 20
Quantity (bbl./day)
Net Benefit =15-18=-$3
77
Floor only
CS =
PS =
Gov. pays
Consumers
Producers
Net Benefit =
Price ($/bbl.)
Price Floor -- $___/bbl.
20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
Floor
0
2
4
6
8 10 12 14 16 18 20
Quantity (bbl./day)
78
Floor only
CS = 0.5(8)8 = $32/day
PS = 8(3)+0.5(8)4= $40/day
Consumers lose
= 32 - 50 = -18 $/day
Producers gain
= 40 - 25 = $15/day
Net Benefit =15-18=-3
WAIT! IF 14 BBL ARE MADE,
THEN . . .
Price ($/bbl.)
Price Floor -- $12/bbl.
20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
Floor
0
2
4
6
8 10 12 14 16 18 20
Quantity (bbl./day)
79
Floor & Gov’t buy excess
CS =
PS =
Gov. pays
Consumers
Producers
Net Benefit =
Price ($/bbl.)
Price Floor -- $___/bbl.
20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
Floor
0
2
4
6
8 10 12 14 16 18 20
Quantity (bbl./day)
80
Floor & Gov’t buy excess
CS = 0.5(8)8 = $32/day
PS = 0.5(7)14 = $49 /day
Gov. pays=(14-8)12
= $72 to buy 6 bbl/day;
cost to produce = $63
surplus not consumed
Consumers lose
= 32 - 50 = -$18/day
Producers gain
= 49 - 25 = $24/day
Net Benefit =24 - 18 - 72
Net Benefit = -$66
Price ($/bbl.)
Price Floor -- $12/bbl.
20
18
16
14
12
10
8
6
4
2
0
Demand
Supply
Floor
0
2
4
6
8 10 12 14 16 18 20
Quantity (bbl./day)
81
Which policy is “second best”?
Party
Quota Subsidy Floor
Consumer
&Taxpayer
-18
-36
-90
Producer
15
24
24
Society
-3
-12
-66
Depends on ed and es
82